In the U.S., the Fed is scheduled to end its bond purchase programme by the end of October. However, there is considerable uncertainty about the pace and timing of increases in short-term interest rates. If the unemployment rate falls faster than the Fed anticipates (as has consistently been the case in recent years), the Fed may well move more aggressively than the market expects.
However, even an accelerated pace of tightening starting in 2015 may be too late to avoid a bout of higher inflation and interest rates due to the limited long-term potential growth rate of the U.S. economy. Ultimately, this slower growth rate may support lower long-term interest rates and higher price-toearnings (P/E) ratios. However, the medium-term outlook could be difficult for fixed income markets, with potential for higher volatility in other financial markets.
A potential problem
In economics, potential GDP growth can be defined as the growth rate the economy would achieve if it were to grow steadily starting from a position of “full employment.” Full employment, in turn, is often defined as the level of employment that prevails when the unemployment rate has fallen to a level consistent with stable inflation. Below this level, the labour market gets so tight that wages begin to accelerate, setting off higher inflation. Many economists and Fed officials believe that full employment today implies an unemployment rate of between 5% and 6%.
Once unemployment has stopped falling, how fast can we expect the economy to grow? In other words, what is our potential growth rate? For many years, this has been regarded as a side issue for the U.S. economy as it struggled to recover from the deep recession of 2008 to 2009, which pushed the unemployment rate up to 10.0%. However, today, with the unemployment rate back down to 6.2%, it is far more relevant.
Prospects for slower growth
Over the past 50 years, the U.S. economy has grown at an average rate of 3% per year, which, given the cyclical position of the economy at the start and end of this period, can be regarded as the potential real GDP growth over that period. However, going forward, it looks like potential growth in the U.S. will be much closer to 2%. Why is this?
In the simplest of models, economic output is the product of labour and the productivity of that labour. When recovering from a recession, labour supply can be increased by simply reducing the number of people who are unemployed, or by relying on demographic trends to increase the number of people in the labour force. However, once the unemployment rate stops falling (and assuming average hours worked per person is steady), labour supply growth must come from labour force growth. And this is clearly a problem for the American economy right now. Over the past five years, the U.S. labour force (defined as the population over age 16 either working or actively looking for a job), has risen by only 2.3 million people to 156.0 million, or at a rate of just 0.2% per year. This has occurred despite an increase of 10.1 million in the population over age 16 over the same period. The slow growth of the labour force has led to a sharp decline in the labour force participation rate, as shown in Exhibit 1.
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